Leading the Way is a column written by PricewaterhouseCoopers professional staff. It appears in the Business section of the Bangkok Post twice each month. The column provides specialised advice to corporate decision-makers in Thailand on global and local business trends.
This article appeared in the May 6, 2008 issue of the Bangkok Post.
By Amornrat Pearmpoonvatanasuk
Picture this scenario: A Thai mine developer commits to pay a power station a fixed amount per year, regardless of the amount of electricity generated. The power station is located at a remote mine site and is not connected to the local electricity grid.
The mine developer is meticulous when doing the accounting for the mining project. However, he makes a vital mistake in how he interprets the agreement he has made with the power station. According the International Financial Reporting Interpretations Committee 4 (or IFRIC 4), when he entered into the agreement with the power station to purchase electricity, he inadvertently agreed to lease the power station. By not properly accounting for this "lease", the developer has made an error on his financial statements. This article highlights the issues companies may face in regard to "Lease Accounting".
In general, there are no differences in determining finance leases and operating leases between Thai Generally Accepted Accounting Principles (Thai GAAP) and IFRS. However, an interpretation under IFRS (IFRIC 4) expands the concept of how to evaluate whether an arrangement contains a lease within the scope of International Accounting Standard 17 (IAS 17). There is no such guidance or interpretation under Thai GAAP.
IFRIC 4 helps companies assess whether they have a "plain-vanilla" supply contract or whether, in substance, there is actually a lease embedded in the contract.
Companies sometimes enter into arrangements that do not take the legal form of a lease but which nevertheless convey a right to use an asset in return for a payment or series of payments. Examples of arrangements in which one company (the supplier) may convey such a right to use an asset to another company (the purchaser), often together with related services, include:
- Outsourcing arrangements (e.g. outsourcing the data processing functions of a company);
- Services that require specific equipment (e.g. a company providing drilling rig services may be considered to be leasing the rig equipment); and
- Take-or-pay and similar contracts, in which purchasers must make specified payments regardless of whether they take delivery of the contracted products or services (e.g. a take-or-pay contract to acquire substantially all of the output of a supplier's power generator, as in the example at the beginning of this article).
IFRIC 4 sets out criteria to determine whether an arrangement is, or contains, a lease based on the substance of the arrangement. This means assessing if:
- the fulfilment of the arrangement is dependent on the use of a specified asset or assets; and
- the arrangement conveys a right to use the asset(s).
To determine whether the fulfilment of the arrangement is dependent on the use of a specified asset, one has to examine the asset. Has the asset been implicitly specified in the arrangement? Does the supplier own or lease only one asset with which to fulfil the obligation? Is it commercially feasible or practical for the supplier to fulfil the arrangement by providing use of alternative assets?
Factors that might affect one's ability to use alternative assets are the assets' locations, the availability of alternative assets, and the assets' cost of installation.
Consider the example at the beginning of this article: Company A enters into an agreement to sell electricity only to a mine site. In order to fulfil this agreement, Company A builds a power station next to the mine site. Company A does not have access to any other electricity generating assets. In this case, it is clear that fulfilment of the agreement is dependent on the use of the power station built next to the mine site. Therefore, the first criterion in IFRIC 4 is met even if the agreement does not specifically identify the asset.
An arrangement may be considered to convey a right to use the asset(s) if any of the following conditions is met:
- The purchaser has the ability or right to operate the asset(s) or direct others to operate the asset(s) in a manner it determines while obtaining or controlling more than an insignificant amount of the output or other utility of the asset;
- The purchaser has the ability or right to control physical access to the underlying asset(s) while obtaining or controlling more than an insignificant amount of the output or other utility of the asset; or
- Facts and circumstances indicate that it is unlikely that one or more parties other than the purchaser will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset(s) during the term of the arrangement, and the price that the purchaser will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.
Consider this second example: Company A enters into an agreement to sell 5% of its output to a mine site while the remaining 25% of its capacity will be sold to other industrial companies. In this case, the mine site does not utilise the full capacity of the power plant, therefore this arrangement may not be considered as a lease arrangement.
How does this affect your company? IFRIC 4 is set to produce changes to how companies have historically presented items, such as property, on both the balance sheet and on the income statement. When an arrangement is made within the scope of IFRIC 4, cash flows under the arrangement must be separated into their respective components. The components frequently include the right to use the asset, service agreements, maintenance agreement and fuel supply.
The payments for the right to use the asset are accounted for as "lease", including classification of the right of use as either an "operating lease" or a "finance lease". The accounting for the other components is in accordance with the relevant accounting standards.
If an arrangement contains an operating lease, the specific asset leased remains on the balance sheet of the supplier. However, operating lease payments are recognised on a straight-line basis over the life of the lease.
If an arrangement contains a finance lease, the specific asset leased is recorded on the balance of the purchaser and not the supplier. The supplier recognises a lease receivable on the balance sheet and the finance income in the income statement.
As this will generally have a significant impact on your financial statements, Thai companies should re-examine their arrangements to determine if any contain leases as defined by IFRIC 4.
